How Will Your Social Security Income Be Taxed In Retirement?

August 13, 2018

Many of us dreamily envision the possibility of retiring someday; you know, making work optional, taking a permanent vacation, etc. While we can retire from the world of work, retiring from the world of taxes is typically not an option, as many retirees are surprised to learn.

Tax obligations may not be part of our retirement dreams, but perhaps they should be. The decisions we make about saving and investing for our retirement dreams while we are still working can help prevent a tax nightmare after we retire.

Your retirement income tax bite

As you might imagine, retirement is a popular reason for people to chat with a financial planner, and I have the pleasure of talking almost daily with people from all walks of life about their retirement concerns. Most people understand that pension income and distributions from traditional 401(k) and traditional IRA accounts will be taxed as ordinary income. One thing that surprises me though, is how many people are not aware that a significant portion of their Social Security retirement benefits will most likely be subjected to ordinary income tax as well.

Social Security is not (always) tax-free

If Social Security is your only or primary source of income in retirement, your benefit may not be taxable. However, if you have income from other sources as well (e.g., pension, distributions from a pre-tax IRA or 401(k), part-time work, self-employment, interest, dividends, etc.) that add up to a certain amount, then a portion of your Social Security will also be subject to income tax. Just how much of your Social Security is taxable will be determined by your combined income.

How to calculate whether you hit the income limits

Sometimes referred to as “provisional income,” your combined income figure is calculated as the sum total of adjusted gross income plus nontaxable interest (yes, that’s your municipal bond income) plus ½ of your Social Security income. Your combined income determines how much of your Social Security income is taxable, and the amount subject to income tax could be 0%, 50% or 85% (or even 100% in one special case). (Don’t panic – it’s not a 100% TAX, that’s the percentage of your SS that will be taxable!)

Adjusted gross income (line 37 on Form 1040)
+
Non-taxable interest (line 8b on Form 1040)
+
1/2 of what you received in Social Security (from Form SSA-1099)
_______________________________________________
Income for Social Security taxation purposes

A good rule of thumb is that if your other income is more than $44,000, you’ll be paying taxes on Social Security no matter what. Less than that (or if you’re not married), refer to the chart below.

 

Combined Income Limits for Taxation of Social Security Retirement Benefits

Taxable SS Amount	Single, Head of HH, Widowed, Married Filing Separately IF apart entire year	Married Filing Jointly
0%	Less than $25,000	Less than $32,000
50%	Between $25,000 – $34,000	Between $32,000 – $44,000
85%	More than $34,000	More than $44,000

Note: If you are married and filing separately but you lived with your spouse even one day out of the year, all of your Social Security retirement benefit will be taxable for that tax year.

 

Roth to the rescue

If you think there isn’t much you can do about your taxes in retirement, you might be surprised to know that you have more control than you think. If you still have a few years to go until retirement, or if you plan to work part-time after you retire, a tax-free Roth IRA can help you keep the tax man at bay.

Here’s why: although the combined income calculation for determining Social Security benefit taxation includes non-taxable interest income (e.g., municipal bond interest), the calculation does not include Roth IRA or Roth 401(k) distributions.

You read that correctly.

Money you take out of a Roth account (assuming it has been in there at least five years) is not subject to income tax, nor does it affect how much of your Social Security is taxable. Accumulating Roth assets during your working years, including converting some traditional IRA/401(k) dollars to Roth accounts, can pay off hugely in retirement by giving you a source of tax-free income that reduces your combined income for Social Security purposes and potentially lessens the tax bite on that benefit.

Remember, you can even convert traditional/pre-tax retirement dollars to Roth IN RETIREMENT, although you’ll have to pay taxes on the amount you convert. However, that’s one way to plan ahead to hopefully avoid taxation of your Social Security in the future. If you want to read about more strategies for reducing your taxes in retirement, my colleague Erik Carter wrote about several strategies in one of his Forbes articles.